Wendells donut shop is investigating the purchase of a new $18,600 donut-making

Question

Wendells donut shop is investigating the purchase of a new $18,600 donut-making machine. The new machine would permit the company to reduce the amount of part-time help needed, at a cost savings of $3,800 per year. Also the new machine would allow the company to produce a new style of donut, resulting in the sale of 1,000 dozen more donuts per year. There is a contribution margin of $1.20 per dozen donuts sold. The new machine will have a 6 year life.

1) what would be the total cash inflows associated with the machine?

2) what would be the IRR (internal rate of return) on the new machine?

(You don't need to do item 3)

Explanation / Answer

1) Total annual cash inflows associated with the machine = Cost savings per year + Additional contribution margin from expended sales = $ 3,800 + $ 1.20 x 1,000 = $ 5,000

2) PVA factor = Initial investment in the machine / Annual cash inflows = $ 18,600 / $ 5,000 = 3.72

Consulting the PVA tables, the closest discount rate with PVA factor of 3.72 at 6 years is 16% approx.

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